When law professors Michael Ohlrogge and Michael Klausner first started studying special purpose acquisition companies four years ago, they were stunned by what they found. Looking at companies that had merged with SPACs in 2017 and 2018, the valuations were so terrible that the professors wondered why anyone would resort to going public via a SPAC.
But the professors were quickly disabused of their study’s conclusions. “Everybody told us, ‘Oh, no. The 2015 IPOs, the 2017, 2018 mergers — everybody knows those were the bad ones. Now they’re different,’” recalls Ohlrogge, an assistant professor at New York University School of Law.
So the professors threw out all their work and collected a whole new batch of data based on 2019 and 2020 SPACs — but their bottom-line conclusion wasn’t any different.
SPACs are a complicated, opaque investment structure in which sponsors raise money in an initial public offering — creating what’s known as a blank-check company — and then go out and find a company to buy with that box of cash. To accomplish this task, they offer the IPO investors an incredible deal: a money-back guarantee on their initial $10-per-unit investment, including shares and warrants plus interest. The sponsors themselves skim a lot off the top, taking 20 percent of the IPO units for a nominal fee.
Ohlrogge and Klausner, a professor at Stanford Law School, discovered that these costs quickly added up: The dilution from warrants issued in the IPO, along with virtually free shares for sponsors and banking fees for both the IPO and the merger that ended up being two to three times higher for a SPAC than for a traditional IPO, all ate into the amount of cash the companies had once the merger happened. Because the companies passed on these costs to the remaining shareholders, the companies ended up with about 40 percent less cash than they started with.
“And then they’re trying to turn a profit for their investors when they’re starting 40 percent in the hole,” Ohlrogge explains. “That’s just really hard to do, and there’s just very few sponsors who can surmount that on a regular basis.”
The stock prices bear out the analysis. More than 300 companies that have gone public via SPAC mergers since the start of 2018 have averaged a loss of about 33 percent from the IPO price of the SPAC, versus an average loss of 2 percent for the 1,000 other companies that chose to go public through a traditional IPO as of mid-April, according to Renaissance Capital, which tracks IPOs. Compared with the S&P 500, which gained more than 50 percent during that time, the SPAC numbers are little short of a disaster.
But in October 2020, when the professors published their study — “A Sober Look at SPACs” — the stocks of SPACs were soaring even before the sponsors found targets. Few would listen to the criticisms.
“People were like, ‘Oh, no. The ones you analyzed, everybody knows those were the bad ones. It was obvious. But now they’re good,’” Ohlrogge told Institutional Investor in a recent interview.
Investment bankers, investors, and SPAC sponsors all sang the same refrain: “It’s different this time.”
To be sure, SPACs had previously been a murky backwater of finance; they were known as the vehicles through which second-tier private equity companies dumped their dodgy holdings into the market by offering IPO investors — mostly hedge fund buyers known as the SPAC Mafia — free money in the form of easily redeemable shares and warrants. Following the financial crisis of 2008 — which halted SPAC issuance for a few years — the Securities and Exchange Commission decided to let IPO investors vote for the prospective merger even if they wanted to cash out, at which point they could get all their money back, with interest, and keep their warrants.
Ohlrogge and Klausner weren’t the only people trying to sound the alarm about the structural weaknesses of the SPAC model. Pershing Square Capital CEO Bill Ackman, who launched the world’s largest SPAC with $4 billion in July 2020, criticized SPACs’ free sponsor shares as “egregious” and said he would take none. He also changed the terms of his SPAC’s warrants to entice investors to stick around, limiting the warrants’ potential for dilution.
Short-sellers also recognized trouble was brewing. Hindenburg Research founder Nate Anderson became famous in September 2020 for his truck-rolling-down-a-hill video exposé of electric-truck maker Nikola — the first big SPAC short during the boom and one that was followed by criminal charges against founder Trevor Milton, who has pled not guilty.
“SPACs have always been an inferior way to go public. But they are a quick way to go public,” says Anderson, who went on to target five other so-called deSPACs — postmerger SPAC targets. They include Clover Health Investments, Lordstown Motors, DraftKings, Pure Cycle, and Tecnoglass. “There is still an extensive number of companies that are trading at multibillion-dollar valuations that are worth nothing at all,” Anderson notes.
But such warnings were largely ignored as the new crop of SPACs were sponsored by top-notch Wall Street players like hedge funds and venture capital and private equity mavens. The list of brand names is practically endless, including people like former Goldman Sachs CEO Gary Cohen and former Citigroup banker Michael Klein; investing pros Barry Sternlicht and Bill Foley; tech superstars Reid Hoffman and Chamath Palihapitiya; hedge funds Pershing Square, Starboard Value, Glenview Capital, and Third Point; and private equity funds Apollo Global Management, KKR, TPG Capital, and Fortress Investment Group.
Big banks like Citigroup, Credit Suisse, and Goldman Sachs were suddenly topping the SPAC underwriting league tables, while multibillion-dollar hedge funds Millennium Management, Magnetar, and Citadel became some of the biggest investors in SPAC IPOs. Institutional investors Fidelity, BlackRock, and T. Rowe Price were also moving heaven and earth to get allocations into PIPEs — private investments in public equities — which supplied the additional capital required for SPACs to consummate their merger deals, especially when many IPO investors redeemed.
Surely the combination of all this smart money would make SPACs better. But it didn’t. A few months after Ohlrogge and Klausner suggested taking a “sober look” at SPACs, the bubble began to burst. Instead of recognizing that the analysis was spot-on, however, SPAC participants had another answer. “Now I’ve had people tell me like, ‘Oh, everybody knows that the late-2020 and early-2021 SPACs are the bad ones. It was just too much optimism and too bubbly. Now they’re good,’” Ohlrogge recalls.
“There’s no limit to how many times people can make this claim,” he adds, sighing.
The SPAC model has always been an ingenious, if complicated, way to convince investors and companies alike to hop aboard the gravy train, and now sponsors (and their bankers) are coming up with creative ways to keep it chugging along. But Ohlrogge says some of the new features are only making things worse.
“They have the potential to turn into a death spiral for SPACs.”
Although the Lucid deal was the apex of SPAC froth, the SPAC downturn picked up momentum a little more than a month later with the demise of Bill Hwang’s Archegos Capital Management, which last month was indicted for fraud in federal court, along with Hwang. According to Peter Hébert, co-founder of venture capital firm Lux Capital, when Archegos blew up in late March, “prime brokers started to rein in risk, and that drained liquidity from the traditional SPAC players. It also happened to coincide with a peak insanity, when two people and a dog were basically declaring a SPAC and raising money.” (Lux is an investor in nine companies that merged with SPACS and, like so many, are trading below their offering prices. Two other companies in which Lux has invested have SPAC deals pending.)
Today the SPAC market is in disarray, as redemptions, regulations, and ruin mount. In 2022 there have been only 67 SPAC IPOs, raising some $11.6 billion, compared with 613 raising $162.5 billion last year. As of late April, SPAC sponsors were canceling their planned IPOs at a furious rate, with Bloomberg reporting that some 62 SPACs that were slated to raise more than $17 billion have nixed those plans. Since its peak in June 2021, the deSpac Index was down more than 70 percent as of May 10.
One reason: SPAC investors who can vote for the merger deals but sell out on the announcements and get their money back are doing just that. Redemptions in 2020 averaged 80 percent and are now at about 90 percent, according to market sources.
“High redemptions say the deal is not attractively priced,” says one long-term SPAC investor at a family office. “In the majority of SPACs, the valuations are not sustainable outside of the SPAC conference room where the SPAC target, sponsors, accountants, and lawyers and bankers are high-fiving each other.”
He bemoans that “every day a deal closes, the stock just goes straight down.” For a recent example, he points to ECP Environmental Growth Opportunities’ deal with Fast Radius. When it was finalized in February, more than 90 percent of the SPAC’s IPO investors redeemed and the stock quickly went from $10 to under $1 per share.
Consider what has happened to the SPACs sponsored by LinkedIn founder Reid Hoffman and tech entrepreneur Mark Pincus. Their Reinvent Technology Partners has launched four SPACs, only three of which have closed. The first went public in September 2020 — as the boom was getting underway. When it agreed to merge with Joby Aviation on August 10, 2021, 62 percent of the IPO’s initial investors elected to redeem their shares. When the second one, with Hippo Insurance, closed on August 2, some 84 percent of shareholders wanted out. Hippo’s stock now trades around $1.60; Joby Aviation is below $6. The most recent deal, with Aurora Innovation, closed in November and trades below $4. More than 77 percent of its IPO investors opted to redeem.
The rising level of redemptions leaves the funding for the merger deals almost entirely up to PIPEs. “The PIPEs are a foundational cornerstone of a successful SPAC deal. If you find institutions to validate the transaction and its valuation, then any other investors may choose to leverage that due diligence to get comfortable with committing capital to it,” explains Ben Kwasnick, founder of SPAC Research, which tracks the market.
But there isn’t enough money coming in from PIPE deals to fill the hole. This year, PIPEs have raised only about $2.8 billion, compared with almost $14 billion in the peak month of February 2021, according to data provider SPACInsider. Fidelity, which has done $32.2 billion in PIPE investments in the past three years, made its last one in October, and BlackRock, which committed $24 billion to PIPEs during the same time period, did its last in July. Those two firms account for more than 60 percent of the $88.1 billion of PIPE money that has been raised in the past three years, according to SPACInsider.
PIPE investors have also been losing money. Last year, Michael Cembalest, chairman of market and investment strategy for J.P. Morgan Asset Management, tracked the shifting returns for different classes of SPAC investors, and the numbers for PIPE investors weren’t pretty. Although some now are getting big discounts, PIPE investors historically paid $10 per share — but without the redemption rights of the IPO investor. And by August of last year, PIPE investors were in the red (down a median 3 percent) on the commitments they had made since January 2019, compared with a median gain of 30 percent by mid-March of 2021. Cembalest hasn’t updated his numbers, but market participants confirm that PIPE investors have continued to lose money this year.
Those investors have “sold out virtually everything,” says Lux Capital’s Hébert, who argues that is because they have viewed SPACs as an asset class. Without these investors, deals aren’t getting done, which means that some 600 SPACs out of about 1,000 that have gone public since 2020 and raised a total of $257 billion in their IPOs are frantically looking for partners. “There is definitely an air of desperation out there,” he says. Lux Capital raised its own SPAC but has yet to find a deal and may decide to liquidate it.
Lux would be in good company, as at least half of these still-searching SPACs are expected to liquidate and return capital to investors this year. One high-profile one could be Ackman’s $4 billion Pershing Square Tontine Holdings, which has yet to announce a deal with a merger partner after its plans to take a stake in the IPO spin-off of Universal Music Group from Vivendi was nixed by the SEC last summer. Tontine’s 24-month time period to reach an agreement with a merger partner ends in late July, and litigation and proposed SEC rules make it unlikely Tontine will extend the time frame.
“There are a handful of people who will ultimately hand back money because they were unable to get a deal done,” says Hébert. “We have our reputation to uphold. And if there is not a good deal to be done, well, God damn it, we’re not going to do it.”
Palihapitiya took his first SPAC public in September 2017 with little fanfare. Twenty-two months later, he was running out of time to find a merger partner before he would have to return the cash he had raised — $690 million. So in July 2019, his SPAC agreed to merge with Richard Branson’s Virgin Galactic, a loss-making pie-in-the-sky venture. It would become the first publicly traded company whose business plan was to send tourists to space.
Virgin Galactic went public on October 28, 2019, and only 23 percent of the original IPO’s shareholders opted to redeem. Those that stuck around initially did well: By February of the next year, the stock was trading over $33 per share — more than triple the $10 per share for the IPO. The rocket emoji symbolizing it became a favorite among the Reddit crowd of retail investors who began to surge into SPACs both pre– and post–merger announcements.
The Virgin Galactic frenzy, coinciding with triumphs by Elon Musk’s SpaceX and Jeff Bezos’s Blue Origin, would send the stock soaring past $55 per share last year — before it fell off a cliff when Palihapitiya sold his stock, pocketed $200 million, and then resigned as chairman. The company’s premerger financial projections were not borne out, triggering investor lawsuits, and the stock now trades under $7 per share. But its performance isn’t the worst of the lot of so-called space deals. Since the Virgin Galactic deal, eight other space companies have gone public via SPACs; their stock prices now average $5.05 per share.
It isn’t difficult to figure out why Palihapitiya glommed on to the SPAC model. As a venture capitalist, he was always looking for exits for companies at his Social Capital VC fund. SPACs had a singular advantage. In a SPAC merger transaction, companies could make all sorts of financial projections about the future, unlike in traditional IPOs, as Palihapitiya bragged on Twitter. That was extremely helpful for the unicorns of the VC world, which had more vision than income or — in some cases — revenues.
“What happened was these high-growth innovative companies said, ‘Wait a second. If I go public with a traditional IPO, I can’t talk about the future. I’ve got all these restrictions,’” says Mark Yusko, founder and chief investment officer of Morgan Creek Capital Management. “‘Hey, there’s this new thing where I can make forward-looking statements. I can talk about my vision for the future. I don’t have to have ten years of operating history.’”
A believer in the virtue of SPACs, Morgan Creek last February launched a SPAC exchange-traded fund, which holds both premerger and deSPAC names. It has fallen by about 60 percent since then, although Yusko argues that many of these companies, like Amazon before them, will eventually fulfill their promise.
But skeptics like short-seller Anderson disagree. “The chart for almost every postmerger SPAC resembles a pump-and-dump,” he says. “I don’t think that’s an accident. We’ve seen several SPACs go public, then immediately rug-pull their own outrageous projections. These were companies that often had zero revenue, that were projecting outrageous kinds of metrics, projecting to completely dominate industries within years or create brand-new industries that would disrupt entire economic ecosystems. It was a rush of garbage flooding the public markets.”
Take, for example, Hindenburg’s most famous SPAC short: Nikola, which peaked at $65.90 soon after its merger with VectoIQ Acquisition Corp. was completed in June 2020. Nikola’s alleged sketchiness notwithstanding, the electric-vehicle SPAC boom continued, culminating in more than a dozen electric-vehicle–related SPAC deals. Aside from Lucid, most of those have also been a disaster for investors, with a current average share price of $6.62, according to SPACInsider. (Nikola is now trading around $6 per share.)
Another of Anderson’s targets was Clover Health, which had merged with one of Palihapitiya’s Social Capital SPACs. It is now under investigation by both the Justice Department and the SEC. Investors are suing Palihapitiya and Clover for misleading them ahead of the merger, and the stock is under $3. (Clover Health and Palihapitiya have denied wrongdoing.)
So far, Palihapitiya has launched IPOs for six SPACs, plus four others with hedge fund Suvretta Capital. Out of the ten SPACS, however, four have yet to find a merger partner and two other pending deals haven’t closed yet. Those that have deSPAC’ed — Virgin Galactic, Opendoor Technologies, Clover Health, and Sofi — are all trading more than 40 percent below the initial $10 IPO price.
If the hype that made such deals attractive early last year has died down, one argument in favor of SPACs is that they are suffering the same fate as all other growth companies. Yusko is quick to point out that SPACs have done better than Cathie Wood’s Ark Innovation ETF, which is down more than 70 percent since the peak in February 2021.
But regulators have also had a hand in popping the bubble. Last spring, the SEC signaled it was going to crack down on the perceived ability of companies merging with SPACs to make forward projections without suffering any legal consequences. Because these deals were considered mergers, SPAC sponsors, target companies, and their advisers believed they were protected by the “safe harbor” provision of the Private Securities Litigation Reform Act of 1995, which limits the ability of investors to sue over financial projections.
IPOs do not have that safe-harbor protection, so they do not make forward-looking financial projections in their prospectuses or for 40 days after shares start trading.
One of the toughest provisions of the new SPAC rules unveiled by the SEC in March would not only end that safe-harbor provision for SPACs, it would also make all of the actors — sponsors, companies, and advisers — liable for false claims made in the deSPAC transactions, just as they are for IPOs. As a result, three top underwriters — Citigroup, Goldman Sachs, and Credit Suisse — appear to have cooled on the business.
Last month, Bloomberg reported that Citigroup has “paused” the underwriting of SPAC IPOs pending clarification of the new SEC rules regarding potential legal risks. Citigroup was the book runner for almost $30 billion in SPACs in 2021, making it the top underwriter that year. It handled 108 of the year’s IPOs for a 14 percent market share, according to SPAC Research. This year it has done only five, raising a little more than $1 billion.
Credit Suisse, the top SPAC underwriter in 2020, has underwritten only one SPAC in 2022. The Swiss bank has formed an internal committee to look at all SPACs, which would then have to be reviewed by the firm’s investment banking committee and the new “tactical deSPAC committee,” notes an individual familiar with the effort.
He says that in the bank’s only 2022 SPAC deal in the U.S., for Investcorp India on May 9, Credit Suisse took no deferred underwriting fees, as a result of concerns over potential liability for the deSPAC transactions. Typically, underwriters take 2 percent on the front end — the IPO — and an additional 3.5 percent when the merger transaction is completed.
Fears about liability are also leading Goldman Sachs, the second-ranked SPAC underwriter in 2021, to exit the market, according to Bloomberg. This year, it has underwritten only two deals, according to SPAC Research.
Citigroup and Goldman did not respond to requests for comment, and Credit Suisse declined to comment.
But though the SEC’s hard line may help stem the flood of shoddy SPACs, it seems unlikely to solve the structural problems that beset the entire sector — which are getting even worse.
To some players, however, the SPAC market seems perfectly rational. First there are the sponsors. Because they pay only $25,000 for 20 percent of the IPO shares, doing a deal — any deal — is profitable unless the merged company goes bankrupt.
And last year, the sponsor returns were wild.
In March 2021, when Cembalest looked at SPAC returns, he found that the sponsors had raked in a median 468 percent return since January 2019, even after accounting for all their concessions, forfeitures, and vesting. By August, that number had gone down to 284 percent — still an almost unheard-of gain on a risk-free trade.
Then there are the IPO investors — the so-called SPAC Mafia, or SPAC arb players. They certainly appear to be rational players. From January 2019 to mid-2021, they made a median 16 percent return, according to Cembalest’s calculations. In fact, their gains were the same in August 2021 as in March of that year.
“It was almost like free money to buy the unit and sell the announcement,” says the family office investor. The SPAC yield, he notes, is still greater than the 10-year Treasury bond. “Why buy government bonds when you can just flip SPACs?”
What’s perhaps most astonishing is that to keep the SPAC machine humming, the terms for these investors — as well as for PIPE investors — have only become more lucrative, according to Ohlrogge and Klausner.
“SPACs have been evolving recently in ways that make them even more expensive vehicles to take companies public, and thus in ways that will likely lead to even worse returns for shareholders who hold their shares through SPAC mergers,” the academics wrote in a new paper published in March.
Ohlrogge and Klausner found, for example, that to lure PIPE investors, an increasing number of SPAC sponsors are letting these institutional investors buy in at steep discounts, typically $8 per share. More-complex and opaque terms for private investments make it even harder to know what they are paying — and how much it will end up costing other shareholders in the end.
The professors highlight a deal by Yellowstone Acquisition for Sky Harbour that had an “equity prepaid forward transaction.” The bottom line is that the investor is loaned money by the company to buy its shares, and if the price of the stock falls below $5 in the 18 months following the merger, the investor doesn’t have to repay it. The deal closed on January 25, almost 90 percent of the shareholders redeemed, and the stock is currently trading around $8 per share.
More-lucrative warrant terms are also being used to entice IPO investors, and the traditional 24-month time frame to find a deal is being shortened to as little as a year, according to the professors.
Another relatively new effort they point to includes overfunding SPAC trust accounts by placing additional funds in them. Instead of $10 per share, the trust accounts now have $10.20, making them still more lucrative for those who paid $10 per share and redeemed, getting $10.20 instead.
But it’s something of a vicious cycle, which could lead to the downward spiral Ohlrogge envisions. Because the sponsors are typically repaid for the overfunding, he explains, “they drain even more value out of the SPAC and they have the potential then to lead to even worse returns for the SPAC at the time of the merger, which then could require even more generous benefits [to be] paid to the IPO-stage investors.”
Says Ohlrogge: “They need to find more ways to entice the IPO-stage investors to buy in, and that’s what they’re doing.” At least they’re trying.
